Thursday, November 1, 2018

Tesla is just one of the
many overvalued companies – mistakenly considered "tech" companies and to which normal rules do not
apply – that have been in business for a decade or more but have shown no ability to generate and
return cash to shareholders. Yet Tesla seems to be closest to the precipice of failure than any of the
others, and perhaps it will be the first domino to fall in a series of long overdue revaluations.

Tesla is not profitable and so it has been (and will be) dependent on continually raising capital in order to survive. It sells an expensive product that will sell poorly in a
downturn. The Tesla customer base consists to an unusually high degree of engineers at overvalued NASDAQ companies - hence the San Francisco Bay area is the premier market for Tesla vehicles. In this way, Tesla is something of a "derivative of itself." That property seems to be a hallmark of manic entrepreneurship - so you also have Musk's ownership of Tesla augmented by margin loans against his stock, which is a pattern with company managers whose businesses tend toward the unsustainable: Michael Pearson, Aubrey McClendon.

If a bear market, recession, or NASDAQ revaluation occurs, we would expect to see Tesla shares significantly decline in value and
therefore the trade makes a nice hedge against long ideas. But it is not clear that Tesla will survive even if the
current boom or bubble continues. Since our previous writing about Tesla,
the Chairman and CEO Elon Musk announced – on Twitter – that he would be taking Tesla private at
$420 per share.

After taking some time to think about it, we decided that we would not be bullied out of our bearish
view by his announcement. The normal pattern with a management buyout is that an insider or
founder decides that the public market is undervaluing the (normally profitable and cash-generating)
company in question, and so essentially swaps the public investors out of the capital structure and
replaces them with debt financing. Obviously management wants to get a good price on the purchase,
so in addition to the normal considerations of honesty and legal compliance it is intelligent to disclose
any problems in the business to the market, so that the market price (which the takeover offer is
compared to) will discount them.

Even the biggest Tesla believers would have to admit that with dusty Tesla inventory piling up in lots
all over the country, very short wait times after relatively few Model 3s from the big reservation list
have been delivered, quality problems, signs of working capital shortages such as mechanic's liens on
the factory and unpaid state taxes... the operation is not running as smoothly as a nice gasoline engine.

So why paint a rosy picture and inflate the purchase price for the business? Why complain so bitterly
about short sellers driving down the price of something that you want to buy? It looked like the buyout
price of $420 that Musk floated was chosen as the highest price that he thought anyone would find
plausible, not as an attractive price to actually pay for the business. And it did turn out that the buyout
was a hoax, and in the short period of time since we last wrote about Tesla, Musk not only conducted this hoax but
was also sued by the Securities and Exchange Commission and then settled the claims against him
pertaining to the fake buyout, though not the other investigations which appear to be ongoing. [Worth reading the fake buyout SEC complaints against Musk and Tesla.]

The best way for Musk to "burn the shorts," which seemed to be his purpose in conducting the buyout
hoax, would be to demonstrate high demand for his cars combined with an ability to earn a profit.
Resorting to fraud to try to burn the shorts suggests to us that good operating results will not be
forthcoming, and that Tesla may be closer to collapse than anyone realizes.

You might ask, would not Musk and Tesla disclose any impending financial difficulties or restructuring
if things had gotten that dire? There are two episodes from his business career that suggest he would
not. According to the Ashlee Vance biography of Musk, Tesla came close to failing in 2013.

Excerpt from Elon Musk: Tesla, SpaceX, and the Quest for a Fantastic Future

By the middle of February 2013, Tesla had fallen into a crisis state. If it could not convert its reservations to purchases quickly, its factory would sit idle, costing the company vast amounts of money. And if anyone caught wind of the factory slowdown, Tesla's shares would likely plummet, prospective owners would become even more cautious, and the short sellers would win. The severity of this problem had been hidden from Musk, but once he learned about it, he acted in his signature all-or-nothing fashion. Musk pulled people from recruiting, the design studio, engineering, finance, and wherever else he could find them and ordered them to get on the phone, call people with reservations, and close deals. "If we don't deliver these cars, we are fucked," Musk told the employees. "So, I don't care what job you were doing. Your new job is delivering cars." He placed Jerome Guillen, a former Daimler executive, in charge of fixing the service issues. Musk fired senior leaders whom he deemed subpar performers and promoted a flood of junior people who had been doing above-average work. He also made an announcement personally guaranteeing the resale price of the Model S. Customers would be able to resell their cars for the average going rate of similar luxury sedans with Musk putting his billions behind this pledge. And then Musk tried to orchestrate the ultimate fail-safe for Tesla just in case his maneuvers did not work.During the first week of April, Musk reached out to his friend Larry Page at Google. According to people familiar with their discussion, Musk voiced his concerns about Tesla's ability to survive the next few weeks. Not only were customers failing to convert their reservations to orders at the rate Musk hoped, but existing customers had also started to defer their orders as they heard about upcoming features and new color choices. The situation got so bad that Tesla had to shut down its factory. Publicly, Tesla said it needed to conduct maintenance on the factory, which was technically true, although the company would have soldiered on had the orders been closing as expected. Musk explained all of this to Page and then struck a handshake deal for Google to acquire Tesla.While Musk did not want to sell, the deal seemed like the only viable course for Tesla's future. Musk's biggest fear about an acquisition was that the new owner would not see Tesla's goals through to their conclusion. He wanted to make sure that the company would end up producing a mass-market electric vehicle. Musk proposed terms under which he would remain in control of Tesla for eight years or until it started pumping out a mass-market car. Musk also asked for access to $5 billion in capital for factory expansions. Some of Google's lawyers were put off by these demands, but Musk and Page continued to talk about the deal. Given Tesla's value at the time, it was thought that Google would need to pay about $6 billion for the company.As Musk, Page, and Google's lawyers debated the parameters of an acquisition, a miracle happened. The five hundred or so people whom Musk had turned into car salesmen quickly sold a huge volume of cars. Tesla, which only had a couple weeks of cash left in the bank, moved enough cars in the span of about fourteen days to end up with a blowout first fiscal quarter. Tesla stunned Wall Street on May 8, 2013, by posting its first-ever profit as a public company—$11 million—on $562 million in sales. It delivered 4,900 Model S sedans during the period. This announcement sent Tesla's shares soaring from about $30 a share to $130 per share in July. Just a couple of weeks after revealing the first-quarter results, Tesla paid off its $465 million loan from the government early and with interest. Tesla suddenly appeared to have vast cash reserves at its disposal, and the short sellers were forced to take massive losses. The solid performance of the stock increased consumers' confidence, creating a virtuous circle for Tesla. With cars selling and Tesla's value rising, the deal with Google was no longer necessary, and Tesla had become too expensive to buy. The talks with Google ended.

So we know that at least once before when Tesla was close to failing, Musk did not disclose that to
investors and in fact lied about shutting down the factory to save cash. Musk gave a speech in 2011 where
he commented on the failure of Solyndra, a photovoltaic solar company which had been given loans by
Obama's Department of Energy:

"The most you could say is that Solyndra executives were too optimistic. They presented a better face
to the situation than should have been presented in the final few months, but then, if they didn't do that,
it would have become a self-fulfilling prophecy of - as soon as a CEO says I'm not sure if we'll survive,
you're dead."

Musk believes that it is appropriate to lie about a company's condition if it is dependent on accessing
capital markets to survive, and if being honest would result in loss of access.

Tesla is being sued by shareholders in Northern District of California federal court in a case called Wochos v Tesla, and the allegations there are telling as well:

"[T]here is a difference between knowing that any product-in-development may run into a few snags, and knowing that a particular product has already developed problems so significant as to require months of delay." In re Apple Computer Sec. Litig., 886 F.2d 1109, 1115 (9th Cir. 1989). As 2017 started Tesla faced an existential crisis. It had burned through more than a billion dollars in 2016 developing the Model 3, diverting profits from its existing luxury cars to satisfy the cash demand for the Model 3. By the beginning of the Class Period, Defendants disclosed that they would mass produce the Model 3 by the end of 2017 despite contemporaneous facts and warnings from executives, suppliers, and vendors that Tesla's timeline was impossible to meet. Tesla had to build and operate automated production lines for the Model 3 body in its Fremont, California facility, and mass produce 5,000 batteries per week in its "Gigafactory" in Reno, Nevada.

First, the Complaint adequately pleads material falsity. In May and August, 2017, in SEC filings and in earnings calls with analysts, Defendants reported on their progress in first building, and then operating, automated production lines in Fremont and at the Gigafactory. Defendants leveraged these statements of present progress, claiming to be on track to meet Tesla's mass production goal by late 2017. These statements of present progress were materially false. Tesla was building small numbers of Model 3s by hand in its beta shop, where prototypes were constructed. In May, 2017, the automated line, itself, was in the very early stages of construction. Tesla continued to build Model 3s by hand as neither the automated production line, nor the body in white line, would produce a single Model 3 in Fremont until at least October, 2017. As with the Fremont facility, it was only in October, 2017 that the first car-ready battery came off an automated line at the Gigafactory. Similarly, supply issues abounded, and workers constructing the automated production line were regularly idle, lacking parts and instructions.

By August, 2017, Tesla was, by its own timeline, supposed to have been in the second month of automated production at both facilities. Again, Tesla told investors about progress they claimed had already occurred in Fremont and at the Gigafactory that supported its readiness to mass produce the Model 3 in 2017. And, again, Tesla repeatedly lied. About automated production, Tesla told investors that a "gigantic machine" meant to produce 5,000 vehicles weekly was—at that time—"producing a few hundred vehicles a week." Directly contrary to that statement, not a single complete Model 3 had been produced on the still-incomplete production line in Fremont, necessary robots were not even on site, and all Model 3s continued to be built by hand. Similarly, at the Gigafactory, no automated production occurred until September, 2017, and as late as October, 2017, only two batteries per day were completed. There had been no "great progress." Defendants' warnings of risk to their mass production goals were meaningless in the context of the facts they knew to be true no later than May 3, 2017. Their statements were provably false, and therefore, not forward-looking. Oclaro, 897 F. Supp.2d at 918-19 ("a statement about a past or present fact can demonstrably be proven false" and is not forward-looking). Warnings about possible problems is insufficient to rebut falsity allegations when the risks are no longer theoretical, but have materialized. Nor do Defendants' remaining arguments undermine the falsity allegations. The cases they cite in support of their claim that Plaintiffs must produce Tesla's specific timelines for specific tasks offer no support for this assertion. The "on track" cases they cite are distinguishable; almost all concern financial projections, and not statements of existing fact, on the ground.

So we must look to our own clues about how the company is doing, like the inventory piling up in lots across the country, and the staggering number of high level executive departures from Tesla. Our favorite one recently was David Morton, who joined as a new Chief Accounting Officer on August 6th, only to quit
a month later. He had worked at his previous employer Seagate Technologies for 23 years. The
previous Chief Accounting Officer Eric Branderiz had resigned this March after being in that job for a
year and a half. But those are just a start. This year, the company also lost its President of Global Sales
and Service, Treasurer and Vice President of Finance, Vice President of Autopilot, Chief People
Officer, Senior Vice President of Engineering (Doug Field), and numerous others. The latest Chief
Accounting Officer to resign walked away from a $10 million stock grant that would have vested after
four years.

At the current price of $345, the market capitalization of Tesla is $59 billion, and it is trading at 15
times book value. Valuing it at one times book value (which would be a $23 share price) would give
them full credit for their acquisition of Solar City (which was on the verge of insolvency when acquired
and is now in shutdown mode) and for their investments in automotive assembly facilities (such as their
assembly line in an open-air tent) which produce cars that require more rework than any auto
manufacturer in recent memory. (Buyers of new Model 3s report long waits for service appointments.
Why do brand new and ostensibly mechanically simpler electric vehicles need so much service?)

The Honda plant in Lincoln, Alabama that makes the Odyssey minivan can produce as many vehicles
as Tesla on just one of its two lines, and Honda has 12 plants in the United States alone. Their market
capitalization is about the same as Tesla. They sold about 2 million cars in the U.S. last year and 3.7
million worldwide, at an overall average annual profit margin of about 5 percent. Honda automotive
plus their other businesses (like motorcycles and small engines) earn three to four billion dollars a year.
The market capitalization of Ford is $43 billion, which is only 6 times last year's earnings. They too
have a 5 percent automotive operating margin. They sold 2.6 million cars in the U.S. last year and 6.5
million worldwide.

Ford and Honda each earn about $1,000 net per car sold. For Tesla to justify a higher valuation than
either company, it either needs to match that profit per car and sell more (far more cars than it does
today), or else have a smaller market (but still much larger than current production and sales) and an
order of magnitude higher profit per car than the established automakers.

Ferarri earns about $500 million a year selling cars at a 15% net margin. They sell under 10,000 units
annually at an average of about a quarter million dollars apiece. But Musk's idea has been to move
away from high price and margin, low volume, to compete head-to-head against mass market
manufacturers like Toyota and Honda.

Speaking of Toyota, it produces 10 million cars per year – more than any other manufacturer. The
market capitalization of Toyota is $190 billion. If Tesla could steal Toyota's crown to become the
biggest manufacturer of automobiles with unparalleled reliability, the upside would not be all that high
as a multiple of Tesla's current market valuation.

A naive comparison of the Toyota and Tesla valuations would say that Tesla shares could perhaps
quadruple if it surmounted Toyota, but this ignores the massive amounts of capital, and therefore
dilution, that would be needed in order to be able to grow production. Toyota has $94 billion invested
in property, plant, and equipment, net of depreciation. Toyota trades at about book value, as do Ford
and Honda. (Again, Tesla trades at 11 times book.) Whatever valuation lens through which we look at
the valuation of Tesla, it always seems to be too high by an order of magnitude.

The other automotive manufacturers trade at price to sales multiples of less than one. Tesla had $3.4
billion of automotive revenue in the second quarter. If you annualized this to $13.6 billion and assumed
that Tesla deserved to trade at an opulent multiple of 0.4x sales, that would value the car operations at
$5.4 billion, which is not sufficient to cover Tesla's $7.7 billion of recourse debt. (There may be value
to compensate from the Solar City assets, but the point is to show that on a comparable price to sales
basis Tesla is worth nowhere near the current market capitalization.) By the way, we might have used the Q3 revenue figure except that the 10Q is not out more than a week after the conference call, and anyway the Q3 revenue figure will probably be a high water mark from a burst of Model 3 deliveries.

What owners of Tesla shares fundamentally do not seem to realize is what a legitimate premise of a $50
or $100 billion market cap electric vehicle company would be: a new battery chemistry. If you had
invented that and obtained patent protection on it, and assuming it resulted in significantly better
energy density and lower cost per kilowatt-hour of storage than current batteries, you would be able to
sell a lot of vehicles at an above industry average profit margin.

But... why would you want to? If you invented this better battery, you did not disrupt automobiles. You
disrupted oil. The share of oil used for ground transportation, which would be disrupted by a battery
breakthrough, is a $2 trillion annual market. Inventing that battery and then building vehicles yourself
would require you to raise vast amounts of outside capital to build automotive assembly plants. (Again,
look at Toyota: $10,000 of property, plant, and equipment for each of the 10 million vehicles produced
annually.) Honda and Toyota are fantastic at building vehicles and they do it at a 5 percent profit
margin. What you would want to do is license your battery to these experienced manufacturers and
collect royalty checks based on disrupting owners of oil reserves, not manufacturers of vehicles.

The Tesla battery is a modification of a cell called the 18650, which is a 20 year old laptop battery
technology. Now you see why they are not doing a licensing model – there is nothing for them to
license. Instead, with Tesla you are seeing the end result of the very arrogant Silicon Valley mentality
best expressed by two tweets by venture capitalist Benedict Evans from September 2016.

A key premise for the next decade: it's easier for software to enter other industries than for other industries to hire software people

A decision to take an electric battery innovation and go into automotive production would make even
less sense when you look at the base rate of success in that industry. Check out the Wikipedia page “list
of defunct automobile manufacturers of the United States,” there have been hundreds of failures; not to
mention the equity-extinguishing bankruptcies of some of the brands that have survived. The licensing
model would make much more sense – again, if you had something to license.

Tesla not only did not do a battery licensing model, but they effectively did the opposite. Consider the parts of the vehicle industry that they have decided to in-source versus the ones they have decided to outsource. As we know, they decided to in-source and compete head-to-head on manufacturing. The results have shown that they are worse than their more experienced competition. They decided to in-source the automotive retail, which had not been done before and was not legal in most states. (And still is not legal in eight states). This had been a huge distraction from the manufacturing side and has resulted in abysmal customer service. But of all things to outsource, they outsourced the battery production to a joint venture with Panasonic. What should be the entire premise of an electric vehicle company is not even enough of a competitive advantage to do in house.

The valuation discrepancy of Tesla versus the expert existing automotive manufacturers reminds us of
the 2000s tech bubble, and maybe especially the story of eToys and Toys R Us. A firm called
O'Shaughnessy Asset Management wrote an essay a couple years ago called "Stocks You Shouldn't
Own" and described those two companies this way:

eToys had an initial public offering in 1999. The stock was listed at $20 but by the end of the day, the
stock price had climbed to $77. Valuation peaked in late October 1999, giving it a market cap close to
$9 billion - over two and a half times Toys "R" Us - making it the 64th largest company on the
NASDAQ exchange. Think about how astonishing that is: eToys had revenues of $30 million versus
sales at Toys "R" Us of $11 billion, yet eToys had the higher overall valuation and would have qualified
for the NASDAQ 100.

This is what we are seeing now with Tesla. The fad of "disruption" and adulation for "tech" companies
has reached the point where a company can have a bigger market capitalization with orders of
magnitude less revenue and output than well-run competitors. (And no profits!) Nothing is more
"technological" than making jet engines or drilling horizontal oil wells, yet companies in those
industries do not get a free pass when it comes to making money. Even regular ICE auto manufacturing is highly technological, yet very unlike the software industry. Consider this point made by Daily Kanban:

Automakers like Ford are rightly frustrated by the public and market's readiness to believe Tesla's narrative about disrupting automotive manufacturing, but there's reason to believe that the wildly different standards to which Tesla and other automakers are held actually hurts the would-be upstart. After all, one of the main reasons that KTP [Kentucky Truck Plant] operates so efficiently and with such high quality is that it has no choice. Whereas Tesla has been able to count on investors and analysts to forgive its "production hell" fiascoes, KTP is the beating heart of Ford's business, building some of the most high-margin and in-demand vehicles Ford has ever made.

With the new Expedition and Navigator flying off lots, the vehicles made at KTP are absolutely critical to the financial performance that markets demand. Since every minute of downtime means that at least one margin-padding truck or SUV won't be delivered on time, the people of KTP know that the company's financial performance depends on their perfect execution and attention to detail. Were Ford able to raise capital from the markets whenever its financial performance fell short, it's easy to imagine a plant like KTP cutting corners or making excuses about "production hell." But because Ford isn't coddled like the self-described "disruptors," workers here at KTP know that downtime and poor quality simply aren't an option.

The indulgence of investors towards Tesla has created a hothouse flower that simply cannot compete over the long term in the competitive, for-profit automotive market. Also, amusingly, the "kanban" in Daily Kanban refers to Toyota's scheduling system for lean manufacturing and just-in-time manufacturing, but according to the recent article on Musk by Lora Kolodny, the kanban system is verboten at Tesla:

Behind his back, employees turned to a method pioneered by Toyota, known as "kanban," to solve their problems. In its simplest form, workers using "kanbans" put up workflow charts, schedules and cards around a production line to help keep track of items they have and items they need.

In this case, workers took all the parts out of the boxes around the Model X line, arranged the parts with a clear sequence and labels, and put the parts back into the boxes. If one part was out of sequence or damaged, they'd remove a card and leave it in a box or bag to let the supply team know what needed to be replenished.

The cards helped the teams reduce the clutter, keep a small stock of spares nearby, and find the right parts quickly.

But because kanbans were pioneered by Toyota, workers thought they had to hide their kanban cards from Musk during his visits to the factory. Half a dozen current and former Tesla workers say that supervisors in Fremont warned them that if Musk discovered kanban cards posted around their work areas, they were in danger of being fired.

The bullish theses for Tesla (at the current $50-$75 billion price range) involve the company growing to a $500-$1000B titan like Google, Amazon, Facebook, or Apple. That is actually one of the main expected value calculations that keeps the tech mutual funds invested. They know that Musk is a loose cannon and they could not justify holding without the possibility of 10x upside. But what trillion dollar company ever spent its first fifteen years insulated from concern about profitability?

We referred to the missing 10Q for third quarter 2018, and this is worth developing further. Last week Elon published summary results for Tesla that were the company's best ever, and bulls (and even many skeptics) embraced these unquestioningly. Yet, see the following tweetstorm by Ryan Doherty on Twitter about how Musk's behavior was so at odds with a quarter of good performance.

I want to review the last three months (as of 11/1/18) and see if “The Story” we are presently being told ($TSLA turned a corner in Q3 and is now a highly efficient, well-run, profitable car manufacturer) makes sense given what was happening at the time.

August 7: Elon tweets that he is thinking about taking Tesla private. He follows this up with a blog post explaining his thinking, citing short sellers and avoiding quarterly reporting as reasons. This is a month into Tesla's greatest quarter to date.

August 16: A NY Times article about Elon and his fateful tweets quotes Mr. Musk as saying, "But from a personal pain standpoint, the worst is yet to come." This is halfway through the greatest quarter Tesla has ever had.

September 4: CAO Dave Morton resigns, effective immediately, after less than a month on the job. At this point, Tesla is two months in to a great Q3 in spite of high numbers of employee turnover and executive departures.

September 27: Elon calls off a settlement that had been agreed upon with the SEC, and he tells the BOD that he'll quit on the spot if they don't publicly support him and "extol his integrity". The best Q3 he could have hoped for is wrapping up in 4 days.

September 30: Musk emails his employees and states, "We are very close to achieving profitability, but to be certain, we need to execute tomorrow." This is the last day of a quarter in which Tesla reported net income of $311 million dollars.

October 24: Tesla releases their Q3 numbers; they're great. They've gone from a cash-burning enterprise to one of the most efficient car manufacturers on the planet. On the earnings call, they have no prepared statements about operational adjustments and instead talk about safety.

October 26: Mr. Musk uses twitter to question the FBI's investigation into Tesla, as well as claiming that the tweet that cost both him and $TSLA $20M was "worth it". At this point, Elon is antagonizing regulators even though his company is finally performing at a high level.

October 30: Elon Musk tweets that he has relinquished the roll of Tesla CEO "just to see what would happen". $TSLA is now a profitable and growing enterprise that had the CEO remove his title and confuse the corporate governance structure for kicks.

This is obviously not an all-inclusive list and you could explain away any one of these examples. (Miscommunication, personal reasons, etc) But all of them combined paint a pretty vivid picture. (At least, to me they do) And that picture doesn't match "The Story" we're being told.

Why try to go private? Why pick fights with regulators or threaten to quit when your company is finally executing? Why are so many executives leaving the company during one of the greatest turnarounds in automotive history? Why remove your title of CEO "just to see what happens"?

Why wouldn't Elon, who promised "the short burn of the century" and called the boss of a Tesla critic in an effort to shut him up, spike the ball during the Q3 conference call? Why wasn't he bragging about the operational improvements he made that ruined the short thesis?

In recent weeks, FBI agents have contacted former Tesla employees asking them for testimony in the criminal case. The former employees received subpoenas earlier in the probe, and FBI agents recently have sought to interview a number of them, the people said.

For whatever reasons, the bulls are just not bothered by this. Maybe it is because the civil penalty for his buyout hoax was so low in relation to the damage it caused - $40 million vs billions in damages is a penny on the dollar. It is probably also relevant that Silicon Valley "disruptors" have been allowed, this cycle, to break the law with impunity.

But take a look at this Tesla forum poster's "mega panel gaps" on a Model 3 that was delivered in August. This is a new car that is going immediately from the customer's hands back to the manufacturer's body shop! How "disruptive" is that? And how is that being accounted for exactly?

This is an unbelievable situation: the poor quality of these expensive cars, the executives quitting, the lying management, the bad balance sheet, the paltry sales, and yet the stunningly high valuation. When you add in the ~5:1 returns possible if this garbage pile goes to zero between now and January 2021, it is reminiscent of the opportunities that were available in the spring of 2007.

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